HELOC reduces capital gains

[tgfathergoose]

We are selling our primary residence later this year. We have a HELOC on the property that we used to fix up a rental property last year, so we are still in the draw phase. I know the loan payoff on the primary mortgage reduces the cost basis and therefore would reduce the capital gains. With the value of our house skyrocketing over the past 10 years, we most likely will go over the $500k limit for a married couple on excluding capital gains. Does a HELOC payoff at settlement reduce our capital gain? And if so, should we max out the HELOC before we sell, since we are still in the draw period, to reduce this capital gain obligation?

[fanfare]

your mortgages - primary or HELOC, can't increase your basis and reduce your capital gain.

That's a pipe-dream.

[King-55]

I believe it does not since the loan has no relations to the cost. It served as a means of buying your home.

However if you used the HELOC to make upgrades to the property they would be added to the orig. cost of the property & reduce your tax liability.

[NCperson]

the debt on the property (HELOC or primary mortage) has NO impact on the capital gains

Selling price minus  (original purchase price plus selling closing costs plus capital improvements ON TEH PRIMARY RESIDENCE since purchase) = capital gains. 

also, and I appreciate this wasn't part of the question, the HELOC interest is NOT deductable on Schedule A, as the money was not used to substainionally extend the life of your personal residence.  the HELOC interest is deductible on Schedule E to the extent the proceeds were invested into the investment property. .....

[Critter-3]

Simple way to think on this ... when you took out the loan it was not taxable income  so when you pay off the loan it is not tax deductible.   Only the interest paid on the loan may be deducted based on what the loan was used for.  

[Opus 17]

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@King-55 wrote:

I believe it does not since the loan has no relations to the cost. It served as a means of buying your home.

However if you used the HELOC to make upgrades to the property they would be added to the orig. cost of the property & reduce your tax liability.

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The loan balance has nothing to do with your capital gains.  If you used part of the loan to make improvements, the improvements add to your cost basis and will reduce your gains, but that is true of all improvements, no matter how you pay for them.  The existence of a loan does not affect your capital gains in any way.  Paying off any kind of home loan makes no difference to your capital gains either.

Your capital gain is the difference between the adjusted cost basis and the selling price.  Allowable adjustments to the cost basis are listed in publication 523 and include improvements, as well as certain closing costs.  

https://www.irs.gov/pub/irs-pdf/p523.pdf

Suppose you buy a home for $200,000 and sell it for $800,000, and you made $100,000 of improvements.  Your adjusted basis is $300,000 and your selling price is $800,000 so your gain is $500,000.

Now, suppose you have your original mortgage that is paid off down to $150,000 and you have an HELOC of $200,000 that was used partly for the improvements and partly for other things.  You will get $450,000 of cash proceeds, but your capital gain is still $500,000.   Or, suppose you paid off the first mortgage and your only loan is the HELOC.  Your cash proceeds will be $600,000, but your capital gains is still $500,000.  Or, suppose you borrowed $600,000 in equity debt and used it for fast living.  You will only get $50,000 in cash proceeds, but your capital gain is still $500,000, and you might owe more in taxes than your cash proceeds.  But remember you paid no tax on the $600,000 cash out refinance, which was just a way of cashing out the capital gains early.  Capital gains aren't taxed until they are realized by making them real (by selling the property for a certain price, since otherwise prices can go up or down and until you realize the gain, it's only potentially a gain).  But you pay tax on your gain, not your cash proceeds. 

[NCperson]

@Opus 17 -in this query, the home equity proceeds from the primary residence went toward improvements on the investment property. 

While everything you wrote (as usual) is quite clear, I was hoping you were going to also clarify and confirm that the home improvements you were referencing were solely related to improvements on the primary residence being sold and could not include improvements to the investent property, even though the home equity from the primary residence was the source of the cash used to improve the investment property.  

[Critter-3]

The improvements made to the rental should have been added as an asset on the Sch E/form 4562 period.  What happens to the loan that was used to pay for the improvements and when/how it is paid off is immaterial to the Sch E or the sale of the personal residence.  Once the HELOC has been paid off there will be no more mortgage interest to deduct on the Sch E ... it is just that simple.  

[Opus 17]

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@NCperson wrote:

@Opus 17 -in this query, the home equity proceeds from the primary residence went toward improvements on the investment property. 

While everything you wrote (as usual) is quite clear, I was hoping you were going to also clarify and confirm that the home improvements you were referencing were solely related to improvements on the primary residence being sold and could not include improvements to the investent property, even though the home equity from the primary residence was the source of the cash used to improve the investment property, regardless of how they were paid for.

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What we have here is a complicated mixed situation.  

Regarding the personal residence, the HELOC by itself does not change (raise or lower) the capital gains on the sale of the personal residence.  That's what I was primarily responding to.  The cost basis of the personal home is based on it's purchase price and any improvements made to the personal home only. 

Regarding the rental property, the improvements made to the rental property are listed as assets and added to the adjusted cost basis, and they are deprecated over 27.5 years, which allows the owner of the rental property to take a gradual tax deduction for the cost of the improvements.  If we want to talk about the rental cost basis and capital gains on the rental, that's an entirely different post.

Now, some readers may be thinking of the HELOC interest.  If the HELOC was not used to improve the taxpayer's personal home, by which it was secured, then none of the interest is deductible as home mortgage interest on Schedule A.  However, if the HELOC was used to improve the rental property, the interest may be allowable as a rental expense on schedule E, assuming the taxpayer can use the tracing rules to properly allocate the interest expense to the rental property.  (The loan does not have to be secured by the rental property to be a rental expense, if the tracing rules are followed.)   But, since the HELOC will be paid off as part of the sale of the personal residence, there will be no further ability to deduct interest as a rental expense, since there is no more interest available to be allocated to the rental property.

Going back to the top post,

Does a HELOC payoff at settlement reduce our capital gain?

No. See publication 523 and the previous answers. 

And if so, should we max out the HELOC before we sell, since we are still in the draw period, to reduce this capital gain obligation?

That is irrelevant.  Drawing the HELOC will only change the time at which you receive the proceeds from the home sale, not the capital gains calculation.  You might draw $500,000 now and receive nothing further at settlement or you might leave the HELOC alone and receive $500,000 at settlement.  It doesn't change the gain calculation.

However, to obtain maximum benefit from the rental property, you should not draw on the HELOC from the personal home to make improvements on the rental property, because when you sell the personal home, you won't be able to deduct interest as a rental expense.  You should try and borrow against the rental to make improvements on the rental, since that way you can deduct the interest as a rental expense.